Increasing the robustness of the global financial system

OK, now that we’ve sorted out the crisis-management side of the global financial crisis, and have stabilized the banks, how do we structure the global system to be more robust? Here are a few principles and ideas for robustness that a few of us here in Geneva and elsewhere have been throwing around recently in conversation. You’ll note that biological and medical analogies feature regularly – we’re definitely getting an evolutionary biologist in on our discussions!

Avoiding a crisis

Monitoring – a robust system expends significant effort avoiding danger. Think of how meerkats keep a constant lookout in shifts.

Balancing feedback systems – a robust system has a sense of its own equilibrium, and will automatically adjust when one part shifts out of its normal, “healthy” range. For instance, if your heart rate goes up to 200, your body doesn’t declare a new paradigm and write a book called “HR10,000“, arguing that your body’s HR will inevitably definition rise to match the frequency of your brain waves – no, it works to bring it back to 60.

Communication – a robust system has a well-defined set of emergency calls that demand action when danger is sensed and to warn others.

Trust and common goals – a robust system is a trusted system between elements working for survival – there is little or no gaming between players regarding mission-critical aspects of the system, lest those elements fail and everyone loses.

Slowing the spread of the crisis

Pre-prepared response plans – a robust system has a play-book for crises, built up by experience (think acquired immunity) or prior design (your immune system architecture etc).

Fast response units – like those US airplanes continually circling the earth, or our store of white blood cells, a resilient system will have the capacity to immediately deploy elements to try and prevent an attack on a system, using the play-book to respond.

Effective firewalls – like a ship with flood doors, a forest with fire breaks or an ecosystem with gene-barriers, a robust system will have natural barriers to prevent contagion and contain damage to one part of the system. Hetergoneity within the system enhances this. Thanks, Niall

Infection signalling – it’s easy to tell when someone else isn’t feeling well, a sign that perhaps we shouldn’t get too close. A robust system has elements that clearly communicate to others when they are suffering, to prevent contagion as well as promote treatment.

Keeping things going and surviving during a crisis

Redundancy – we have two lungs, right? A robust system has redundancy built right in, and for multiple critical organs. Hat tip, NNT

Degeneracy – (UPDATE: This is the word Nassim used recently that I couldn’t remember, used to mean “an organ that can replicate the functions of another organ when needed”. This meaning seems to be also used in quantum mechanics/mathematics contexts). A robust system will have elements that can mimic or take over other critical functions when required. Thanks NNT

Priority stabilization mechanisms – robust systems already know which parts of the system are critical and will shift resources to solve the most critical problems first.

Adaptation – robust systems will change their behaviour better to survive the crisis

Self-generated remedies – apparently the body can synthesize chemicals for pain relief, and has a variety of means for attacking infection and riding through viruses, which are far more important than the range of placebos we pump in from the outside.

Backups/Indestructible seeds – a robust system will have copies that will survive and have the ability to reproduce when the crisis has past.

Post crisis renewal and adaptation

Effective learning loop and memory – a robust system, either through experience or evolutionary mechanisms, will learn from the crisis and change to become less susceptible the next time

Does this shed any light on the state we’re now in?

Monitoring: FAIL. Our monitoring consisted of Nouriel Roubini and Nassim Taleb (and maybe a few others – Ron Paul?) shouting at an audience who had their fingers firmly in their ears.

Balancing feedback:FAIL. The only feedback system was an inflating bubble – people just defined a new paradigm of growth and ignored the element of leverage in inflating returns. System balancing through the mechanism of a massive financial crisis doesn’t count, by the way…

Communication: FAIL. See monitoring.

Trust: FAIL. People were gaming the system all over the place – this is a bigger debate, however

Fast responders: FAIL. Congress is by definition a slow responder. Although potentially the election timing of the crisis didn’t help. However without a play book this isn’t much good anyway.

Firewalls: FAIL. Globalization has homogenized the global financial system and removed almost all firewalls between economies, enhancing contagion via cross-holdings, macro-economic transmission, trade and currency effects etc (Hat tip to Pete, who pointed out that North Korea hasn’t been affected very much!).

Signalling: PASS. Only just. We’re now starting to see who’s in trouble, but often it’s very late when we do (see Eastern Europe).

Redundancy: FAIL. When our key markets go down and correllations trend to 1, there aren’t many other alternatives for financing.

Degeneracy (SEE UPDATE ABOVE)PASS. The government now seems to be doing almost all the functions of the financial markets!

Priority stabilization: PASS. Just. The government has been supporting the most important functions first via guarantees and liquidity provision. This, however, should be automatic, not manual.

Self-generated remedies: FAIL. The banks and funds are in crisis mode, and generally making things worse rather than better.

Backups/Indestructible parts: PASS. We still have Greenspan, after all.

Learning loop: STILL BEING MARKED. But I’m doubtful that the class will remember anything more than two hours after the test.

So three questions for you. First, what’s the word I don’t know? Second, what elements or categories have I missed from this list? Third, how can we improve these elements in the newly constituted global financial system?

2. I completely agree that communication a.k.a. advance warning has to be an integral part of robust monitoring systems. The question is who should be the target of information dissemination: investors, regulators, politicians, or ordinary people? The design of communication would greatly vary depending on the audience.

3. You mention ‘infection signalling’ but there is another biological process that follows: ejection. The body rejects foreign substances that it is unable to absorb/digest. The financial system, by contrast, absorbed toxins, split them up and distributed them throughout the body hoping the impact would be less chronic.

4. I don’t have a bilogical term for your ‘unknown’ characteristic, but would ‘fungibility’ work?

5. Surely you are jesting about ‘adaptation’ – how did investment banks change quickly?

Overall comment: you have fifteen criteria but, as conceived, I count nine among them that look very similar to the belief in self-regulating market mechanisms (feedback, trust, fast response, signalling, fungibility, priority stabilisation, adaptation, self-generated remedies, effective learning).

Since most of these aspects failed this time, if I were a policymaker I would concentrate my energies on what I can directly influence: monitoring, communication, firewalls, response plans, redundancies and backups, in that order.

Another reader has pointed out (offline) that many of my analogies (potentially the medical ones included) operate within “Bellcurvistan” – an environment where bell-curve swings and reactions are experienced, rather than “Extremistan”, where wild swings and power laws apply. He writes that “in Bellcurveistan the starfish survives by redundancy; in Extremistan only the cockroach survives – response and adaptability is everything.”

He also points out that early warning systems might work for meerkats, but by definition black swans tend to mug you without warning – hence the need for fail-safe systems rather than prevention. Also that financial markets have additional challenges in the form of Soros’s “reflexivity” which introduces further complexity and rapid change.

Interesting stuff – thanks to you both and I’ll update the model when I get a chance!

how about tension monitoring? Many systems of networks become brittle as the slack is squeezed out in the name of efficiency. I a supply chain this is JIT in extremis without buffers. In finance systemic leverage or collective exposure to a a type of gamma risk is the same thing. The tension in the system is cuased by each individual optimizing locally but weakening the system globally (in the math/network model sense).

System slackness is a tragedy of the commons situation in which we sacrifice robustness for speed and leverage.

Thanks Nick! Big fan of your blog by the way, should add it to the roll…

So how would tension monitoring work, and who provides the system slackness? In a global “lender of last resort” example, there would be the ability for someone like the IMF to inject capital and liquidity at times of crisis, but is it possible to alter incentives (or behaviour through other mechanisms) to induce individual players to hold more slack on a long-term basis? It seems that the system itself is set up to optimize relatively quickly, and regulations that require forms of slack don’t hold up well in the complex world of derivatives…

I agree the system doesn’t hold up well in the world of derivatives. I think glass stegal structurally seperating the operators is a good start. banks and companies, that are really just deposit taking hedge funds are not good. I would sacrifice efficiency and scale for simplicity and small size. The world can get along with the big cogs using less leverage and restricted instruments. Yes there will be hedge funds and other operators at the fringes playing their games, but institutions will know who and more importantly what their counterparty is. I think the roles and boundaries for operating parties should be defined and then let them operate within those parameters. Regulated entities entering into CDS should treat them like regulated products. The uncertainty “premium/discount” associated with non-regulated operators would limit risk. In all this mess Madoff’s simple fraud of $50b is a nothing in the context of the “regulated, audited and rated entities”. Transparency and simplicity should come at the cost of efficiency and scale.